The Citigroup Perplex

The banking analyst Dick Bove, of Ladenburg Thalmann, thinks the panic over Citigroup, which has driven the stock down fifty per cent in a week, is unjustified, and that the company is in no danger of failing, given its capital base and the fact that it’s still generating piles of free cash.

I’ll be the first to admit that I don’t understand exactly how most investors value bank stocks, and why they spend so much time fixated on earnings per share and write-offs, etc. So take anything I say with a very large grain of salt. But to understand why Bove’s take might make sense, consider this fact: you could, at this moment, buy all of Citigroup—the entire company—for around four dollars a share, or twenty-two billion dollars. For that, you’d get all of Citi’s branches, all its assets and liabilities, its brand name, Smith Barney, etc.

Now, in buying Citigroup, you would also be buying whatever “toxic assets” it might owns, and whatever bad investments it has made. But the company currently generates, even in these bad times, somewhere between three to four dollars a share in free cash flow. Those aren’t imaginary, mark-to-market dollars. They’re real hard dollars, the kind that come in the door as a result, among other things, of the difference between the interest Citi collects on loans and what it pays on deposits. In other words, at the moment, you could buy all of Citigroup for only a little more than what it clears in free cash every year.

It’s true that in a recession, loan income will presumably fall quite a bit, although the sharp drop in interest rates has obviously allowed banks to make more on each loan they make. So let’s say Citi’s free cash flow will be fifty per cent lower in 2009 than it was in 2008. That would still mean you could buy the company today and in two years have covered the entire purchase price with the cash the company generated.

So here’s what I don’t understand: yes, Citigroup will probably have to make massive write-downs on the value of some of its assets, particularly in areas like commercial real estate. Yes, it’s undoubtedly carrying many assets at inflated values that don’t reflect their true market price. But these assets aren’t, for the most part, generating free cash for Citi at the moment, anyway, so whether their value is written down or not doesn’t affect the company’s free cash flow. And if I’m able to buy the whole company for two times free cash, does it really matter if I have to write down the value of some of its assets, since I’m essentially getting them for free?

I know the picture is far more complicated than this, and I’m leaving out all the messy stuff that keeps banking analysts in business. It’s also true that in order to keep generating that free cash, Citigroup needs to retain the confidence of its depositors (and, to a lesser extent, of its borrowers). If people start to believe that there’s reason to panic, that could actually lead to panic, and slash Citi’s free cash flow very quickly. So I understand why, even at four dollars a share, Citigroup isn’t what a CNBC commentator would call a “table-pounding buy,” especially since it’s a lumbering behemoth that doesn’t seem especially well-managed. But I also understand why Bove thinks that, given its cash flow and its capital position, people shouldn’t be panicking.

James Surowiecki is the author of “The Wisdom of Crowds” and writes about economics, business, and finance for the magazine.